By William L. Watts, MarketWatch LONDON (MarketWatch) -- The European Central Bank may have given up a chunk of its credibility in a headlong effort to save the euro, economists said Monday. Just four days after ECB President Jean-Claude Trichet said policy makers hadn't even discussed the purchase of euro-zone government bonds on the secondary market at their monthly meeting, the central bank on Sunday announced it would do exactly that. The move was announced in concert with the plan announced by the European Union early Monday morning to provide a $971 billion emergency fund to debt-strapped euro-zone countries in an effort to stem a growing sovereign-debt crisis that had threatened to throw credit markets into meltdown. Read about the plan. "I think the ECB has been very reluctant to invoke this nuclear option because it may undermine their inflation-fighting credibility," said Elwin de Groot, European economist at Rabobank in the Netherlands. "But I think they saw that this was a measure that they had to take in order to give more credibility to the euro-zone government plan," he said. Without the ECB moves, doubts might already be creeping in about the long-term effectiveness of the E.U. rescue fund, he said. Spreads between peripheral euro-zone government bonds and German bunds have narrowed sharply and the cost of insuring the likes of Portugal, Greece and Spain against default have fallen as liquidity has returned to markets, analysts said. European shares jumped, with banking shares up sharply on ideas a meltdown of credit markets had been averted. Read about the long-term impact of the plan. Economists have warned that purchases of government bonds could undermine the bank's credibility because they would be viewed as direct monetary financing of excessive fiscal deficits. Such a move blurs the line between fiscal and monetary policy. The central bank's apparent U-turn on the subject also raises questions about the possibility it may have given in to pressure from euro-zone politicians. To combat such perceptions, the ECB emphasized in its announcement that it had taken note of the pledge by euro-zone finance ministers to "take all measures needed to meet [their] fiscal targets this year and the years ahead" in line with the euro-zone's deficit-reduction rules. The announcement also alluded indirectly to pledges by Portugal and Spain to make further deficit-reduction efforts. The moves stop short of the outright quantitative easing engaged in by the Bank of England, which electronically created new money that was used to purchase government bonds from banks in a bid to boost the money supply and avert a deflationary spiral. The ECB says the purchases will be effectively "sterilized" by withdrawing liquidity elsewhere, ensuring that it doesn't boost the money supply. The move, nonetheless, appears likely to open the ECB's balance sheet up to "some incalculable risks," said Neil Mellor, currency strategist at Bank of New York Mellon. "The ECB's assurances that it will responsibly sterilize these purchases brings to mind Gresham's Law, which as commonly stated, is 'bad money drives out good,'" Mellor said, in a research note. "In other words there is a risk that the ECB obligingly mops up poor quality debt resulting, increasingly, in the sale of higher quality assets and a markedly deteriorating balance sheet." The ECB's reputation may now rest on the ability of euro-zone governments to follow through on tough deficit-reduction measures, said Marco Annunziata, chief economist at UniCredit Group. "In the short term, the ECB's intervention will be a crucial element of the package, bringing immediate relief; the longer term implications however could be extremely detrimental," he said. If governments follow through on plans to accelerate fiscal consolidation, "the ECB might still be able to argue that it has offered temporary support to offset impending market dislocations; if they do not, it will be hard for the ECB to fight off the charge of monetizing excessive fiscal deficit," Annunziata said.

Source